Aggressive Sourcing: A Free-Market Approach

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The importance of a strong marketing function is universally recognized, and every company invests enormous effort in “out-thinking” the customer. But how much energy is the corporation, as customer, spending to out-think suppliers marketing to it? The answer in many cases is not much. Most companies have historically neglected the “reverse marketing” function (or “purchasing”), and many Fortune 1,000 companies waste several hundred million dollars each year as a result.

In the 1980s, many manufacturers instigated a purchasing overhaul. However, they focused on purchases that typically fall within the purview of purchasing departments, namely, “direct” purchases or “cost of goods sold.” The vast array of expenditures dubbed “indirect” purchases went almost untouched. A model of purchasing excellence emerged that eschewed free-market competition in favor of supplier “partnerships.” In some cases, companies extended the notion of partnership to cover areas in which it had little applicability. As a consequence, they sheltered many large supplier relationships from rigorous competitive scrutiny and seldom realized the potential economic leverage from hard-nosed reverse-marketing.

During the past few years, some firms — particularly in the service sector — have acknowledged the chronic neglect of indirect purchasing and are redefining canonical approaches to the subject. Companies such as American Express, Sears, and Chemical (nowChase Manhattan) Bank have launched campaigns to tackle indirect purchases head on, using various free-market approaches. The results of these campaigns are impressive; they include a greatly improved understanding of and control over what is being purchased and a 10 percent to 15 percent reduction in the expenses reviewed without any changes in quality or functionality. The bottom-line impact of these dollar savings is obviously material. In a case in which indirect purchases represent roughly 33 percent of operating expenses (not atypical for many companies) and net profit is roughly 10 percent of revenues, a 15 percent reduction in indirect purchases translates into a 50 percent improvement in profits.

We base this article on the phenomenal success of such campaigns. First, we review the scope of the rationalization opportunity. Indirect purchases — for example, mainframes, advertising space, health care benefits, and legal services — represent a significant part of any company’s cost structure. Yet, as they have seldom received adequate attention, they will probably survive the current wave of reengineering unscathed. Since companies generally regard them as “secondary” expenses, which should decrease in volume as “primary” levers such as head count or activity level decline, they seldom address them directly.

Second, we use case studies from our experience with indirect purchasing to challenge the prevailing partnership-oriented method. We argue that, for a significant portion of purchases, the notion of a supplier partnership is perhaps misplaced. In one basic respect, the supplier’s objectives are always at odds with the client’s: one’s revenue is the other’s cost. From the client’s viewpoint, therefore, a degree of tension in the customer-supplier relationship is essential for reducing expenses, and competitive free-market approaches are extremely effective in creating this tension. If our view is correct, we hope to promote a properly capitalist concept of supplier management in which free-market competition constitutes the norm and partnerships must justify themselves as exceptions.

We ask four simple questions:

  1. What are indirect purchases?
  2. Why are they poorly managed?
  3. How should managers address indirect purchases?
  4. How do supplier partnerships differ?

What Are Indirect Purchases?

U.S. corporations spend roughly $12 trillion each year. Nearly $2.3 trillion is for labor (permanent employees), $1.1 trillion for financial items (interest charges, credit losses, and so on), $5.4 trillion for direct purchases (to suppliers for items directly associated with end-products and services), and the remaining $2.7 trillion for indirect purchases (items not directly associated with end-products)(see Figure 1).1 In aggregate, therefore, indirect purchases represent nearly 25 percent of all expenses for U.S. companies.

The proportion of indirect purchases varies by industry and company. In manufacturing companies, the number is generally around 25 percent, while, in the service sector, it is generally much higher. Whatever the ratio, companies spend an invariably large amount on indirect purchases — more than $20 billion for some Fortune 25 companies, and more than $1 billion for the smallest Fortune 500 company.

Although all these purchases share the characteristic of not being directly associated with end-products or services, the term “indirect purchases” is obviously broad, covering many distinct categories of items purchased for different purposes from different suppliers. It is useful, therefore, to divide them into five major functional clusters (see Figure 2):

  • Advertising and marketing expenses amount to nearly $300 billion in aggregate, or 10 percent to 15 percent of most companies’ indirect purchases, and include expenses for producing and placing ads on television or in printed media, expenses associated with direct marketing (printing, paper, letter shops, and so on), and a range of promotional and public relations expenses.
  • Technology expenses amount to more than $500 billion in aggregate, or roughly 20 percent of most companies’ indirect purchases, and include all purchases associated with information technology — mainframe processors, data storage devices, networking equipment, PCs, telecommunications charges, packaged software, and contract programming services.
  • Overhead expenses are those that people typically think of as indirect purchases. Nearly $700 billion in aggregate, or roughly 25 percent of indirect purchases for most companies, they include a wide variety of purchases required to support the company’s infrastructure and day-to-day operations — facilities maintenance, security guards, office supplies, furniture, travel and entertainment, and insurance.
  • Human resource expenses, over 25 percent of indirect purchases for most companies, add up to more than $700 billion in aggregate and include all expenses associated with providing health care and other benefits to employees such as HMOs, indemnity coverage plans, death and disability benefits, and recruitment and relocation expenses.
  • Business-specific expenses amount to roughly $500 billion in aggregate, or 15 percent to 20 percent of most companies’ indirect purchases. This category covers purchases that are generally unique to each industry —collection agencies for financial institutions, store fixtures for retailers, and working gear for manufacturing companies.

Each of the 5 clusters contains roughly 25 to 30 distinct major supplier industries, so there are roughly 125 to 150 distinct major industries supplying indirect purchases to the corporate market. While there are some similarities and patterns, the buying challenges differ considerably across these industries. It is useful, therefore, to think of the purchasing or reverse-marketing of indirect purchases as 125 to 150 distinct buying problems, each of which merits a slightly different solution.

Why Are Indirect Purchases Poorly Managed?

Historically, few companies have paid particular attention to indirect purchases, so, in the main, they have been badly managed. Companies have not recognized the leverage from effectively purchasing these items, and their supporting role has kept them from senior management’s scrutiny. In addition, three systemic problems in most companies prevent effective purchase of indirect items: (1) inadequate information, (2) insufficient resources, and (3) improper techniques.

Inadequate Information

Surprisingly, few companies know exactly what they purchase. To be sure, companies can get “information extracts” from the accounts payable and general ledger systems (AP/GL), but any meaningful categorization into the roughly 125 to 150 categories we mentioned above is generally hard to come by. The category codes and coding process for most AP/GL systems were designed years or even decades ago and have grown organically to meet various information needs. Few relate to effective purchasing. The result is that most systems have anywhere from 5,000 to 50,000 codes and as many as 500 to 5,000 users or clerks interpreting the codes as they process invoices. With poorly designed information outputs and relatively undisciplined inputs, the resulting information base is extremely confusing. Indeed, when reviewing most companies’ accounts payable information, we are surprised that the lack of accurate information has not created serious audit problems.

If simple aggregate data about indirect purchases are hard to get, more sophisticated information about volumes, unit costs, pricing, or quality is even harder. The difficulties go beyond the poor information infrastructure and relate to the elusive nature of indirect purchases. Unlike tires — the prototypical direct purchase with relatively well-defined, stable specifications — many indirect purchases involve services (e.g., advertising agency services) that are inherently difficult to pin down in terms of unit cost or quality, or extremely varied commodities (e.g., PC peripherals), the fragmented nature of which makes synthesized unit cost or quality information very elusive. And external data about benchmarks and alternative suppliers are often even more confusing and elusive than internal information.

Insufficient Resources

Nearly 80 percent of all indirect purchases are approved and negotiated without any formal purchasing process. Some people conducting these negotiations lack necessary sourcing and negotiating skill, and even those with skill have other incentives — to ensure that marketing brochures are delivered on time, that the data center does not have an outage, or that the employee benefits survey shows positive results. Since suppliers often help them meet these objectives, their loyalty to the suppliers is extraordinarily high, often higher than their loyalty to their own company. They are more likely to push to “get the deal signed quickly” than upset the status quo or ensure that they have gotten the best deal in terms of quality, timing, and price.

Even when indirect items are purchased through a formal purchasing process, the resources are frequently inadequate to the task. A Fortune 100 company with more than $2 billion in indirect purchases may have 40 to 50 purchasing staff people overseeing $400 million to $500 million in indirect purchases, largely in the overhead cluster (facilities maintenance, office supplies, furniture, and so on), and trying to indirectly influence or control the remaining expense base. Their challenge is daunting, because they have to outsmart as many as 2,000 to 2,500 sales and marketing personnel from 400 to 500 suppliers. This span of coverage would challenge even a very capable, sophisticated purchasing organization. Unfortunately, companies often assign the best people in purchasing departments to oversee direct purchases, while ignoring indirect purchases.

Improper Techniques

In a perfect market, information about alternatives would be readily and abundantly available, and suppliers would freely and constantly compete for any client’s business. Since the markets for indirect purchases are far from perfect, gathering information and soliciting competitive activity require effort. Purchasers have to find alternative providers, issue requests for proposal, and so on.

Unfortunately, few companies undertake this effort frequently or intensely. In our experience, fewer than one-quarter of all indirect purchases undergo serious scrutiny each year, and nearly half escape examination altogether for many years.2 In most cases, companies renew or revise existing arrangements, generally with their current suppliers. This infrequent or lackadaisical scrutiny is partly due to the resource gap. In many cases, however, it is due to the prevailing view that partnerships with suppliers are preferable to a free-market or competitive approach.

Later, we shall return to the question of whether the prevailing view is correct. Suppliers welcome the absence of frequent, intense scrutiny. The most powerful weapon that buyers have in their dealings with suppliers is knowledge about, and a willingness to use, alternatives. In fact, suppliers commonly reduce prices preemptively to forestall a competitive review.Despite the power of this weapon, most companies seem hesitant to use it regularly.

Each problem we’ve described severely undermines a company’s ability to tackle indirect purchases. Just as it is hard to do effective marketing with inadequate information, highly limited resources, and confused techniques, so it is with reverse-marketing.

How Should Managers Address Indirect Purchases?

Companies obviously have to recognize both the problem and the opportunity. The magnitude of both merits serious senior management attention; the companies that have successfully addressed indirect purchases have focused senior management on the issue. At American Express, for example, Kenneth Chenault, vice chairman (now president), initiated an indirect purchase expense-reduction program, and James Cracchiolo, a senior executive in the company and former CFO at Shearson, led an intensive two-year effort, one of the most important restructuring initiatives at the company. At Sears, CEO Arthur Martinez chaired its program, and Doug Shuman, a senior executive in the Merchandise Group, led a program to cut purchased expenses by $1 billion. Edward Miller, president, and Joseph Sponholz, CFO, championed the effort at Chemical Bank. At Swiss Bank, CEO Marcel Ospel sponsored the effort, and a senior executive, Hanspeter Brüderli, led it.

Those companies that have not devoted senior-level attention to the problem have usually failed to make significant progress. The underlying problems with indirect purchases are too deep and the organizational impact of any solution too broad-ranging to address in a narrow or more clinical way.

The task of controlling relationships with 125 to 150 industries is daunting, and, without a sensible approach, managers assigned to it are unlikely to get very far. Too often, we have seen enormous enthusiasm for simple ideas like “standardizing brochures,” “eliminating unnecessary use of temps,” “right-spec-ing of PC purchases,” and so on fail within six months because of an inability to implement. What then should managers do? Relevant approaches differ from one company to another, not least because the supplier industries are quite different. Nevertheless, we have identified five common techniques that lead to successful programs.

1. Measure Pragmatically

Meaningful information about what to purchase at what price and clarity about what metrics to use for measuring progress are essential. Unfortunately, as we indicated earlier, the existing infrastructure is of little use here, and, while transforming it is ultimately necessary, such a mammoth undertaking is hardly an option in the short run.

Many companies reach for a silver bullet to resolve this dilemma — for example, installing an all-encompassing purchasing system or integrated purchasing/accounts payable system. They hope that if they can process all purchases through such a system, intelligent information will emerge automatically. Unfortunately, these solutions take a long time to implement. Furthermore, unless managers have carefully thought about the desired information outputs (metrics) up front and invest enormous effort in transforming the underlying information sources, the solutions are limited.3

Instead, managers should be extremely selective and focused when defining the information needed and very practical and wily in finding ways to obtain it. In metric definition, while there may be 125 to 150 industries all together, there are generally fewer than 25 supplier industries that dominate the purchases of any company, representing well over 50 percent of expenditures. It obviously makes sense to focus on these. Furthermore, while there is much information about each industry, it is useful to start with a single synthesized metric that summarizes the economics of the company’s purchases from that industry. Ultimately, a manager might want the cost of printing by job, type of print, quality of paper, and so on. However, at the beginning, it helps to know the overall unit cost measured in cents per piece. Whatever a manager ultimately does, whether demand or supply related, success should be measured in a reduction in this metric.

In data collection, short-cuts can circumvent the need for systemwide efforts. Suppliers are generally able and willing to provide most of the information needed. If they can’t, the pragmatic application of the 80/20 rule will often yield sufficient information for making reliable judgments. Purchases of indirect items tend to be concentrated: roughly 10 percent of invoices constitute 90 percent of expenses.4 Even if scrutiny of each invoice becomes necessary, the effort required to create a useful information base is not necessarily gigantic.

2. Assign Resources Selectively

Sales and marketing people representing suppliers frequently outnumber their reverse-marketing counterparts by ten to one. In most cases, companies should increase significantly the level of resources allocated to reverse-marketing. In practice, however, most companies are reluctant to make such an investment. Even if they are willing, finding and retaining capable people is difficult.

The trick is, once again, to be extremely selective: identify the handful of supplier industries (twenty-five or fewer) that account for the majority of expenses and ensure that the right people cover them. This level of resource assignment is generally palatable and manageable at most companies, and, while it does not solve the problem entirely, it secures most of the desired benefit. Should these professionals be part of the corporate center or the various business units? While organizational issues need to be resolved on a case-by-case basis, given the scarcity of talent, centralization may be the right answer.

The job descriptions for these roles must clearly articulate the objective of reducing expenses. To ensure that people focus on the objective — and do not passively administer existing supplier relationships —companies should link their compensation to achievement of results. It is useful to think of these people as traders who receive a low “base” compensation but are rewarded if they outperform the market. If companies design these arrangements well, the resources applied to the reverse-marketing function can be fundamentally self-funding.

3. Demystify Business Requirements

Whenever companies initiate significant reviews of purchases, concerns about quality reduction arise. Underlying this apprehension are two critical, highly questionable assumptions: first, that companies know business requirements or quality needs with precision and, second, that the only way companies can reduce purchased expense is by compromising service or quality requirements. These assumptions are seldom correct. There is generally great imprecision and confusion about quality needs, and in most cases, the “existing service level” is the only definition of business requirements.

This imprecision obviously obfuscates any evaluation of alternatives and trade-offs and works to the supplier’s advantage, since it allows sales savvy to take precedence over economic reality. Indeed, it generally works to the incumbent suppliers’ advantage, because they are meeting business needs and most buyers tend to be risk-averse when examining alternatives.

The language and metrics for establishing precise quality requirements, while crucial to dealing with suppliers and establishing control over indirect purchases, often do not exist. For example, after many years, buyers of ball bearings finally agreed to consider any ball bearing that did not have such-and-such radius (plus or minus some tolerance), such-and-such density, and so on, an “error.” Once they agreed on these definitions, they could begin serious measurement and discussions of quality. But such robust frameworks for computer maintenance services, health care programs, and so on are far from defined.

Fortunately, this level of precision is unnecessary to achieving appreciable business impact. Simple, practical frameworks that improve upon the current disarray often suffice. In discussions about television advertising, for example, marketing executives often insist that the media they are using are uniquely appropriate, even vitally necessary, to their brand. If they are right, the premium they pay to advertise in these media is justified. But often they are mistaken. For instance, in one simple framework, programming was divided into three potential categories: “brand enhancing” (e.g., the Academy Awards or the Super Bowl), “unacceptable” (e.g., excessively violent shows), and “acceptable.” Managers and agencies classified 50 to 100 programs into these three categories. With few exceptions (3 to 4 shows that were unanimously considered brand enhancing and 3 to 4 shows that were unanimously considered unacceptable), the results were quite inconsistent. Armed with this information, managers were able to change the mix of shows and achieve savings of 25 percent to 30 percent without reducing or compromising agreed-on measures of quality.

4. Clarify the Pricing Basis

For a high proportion of indirect purchases, outputs are hard to define, so that pricing becomes an imprecise, somewhat judgmental exercise. There is seldom any doubt, for instance, about the link between the price of a tire or microchip and its underlying output. But this link is much less clear with respect to, say, legal services or a software development project.

Indeed, indirect purchases like software development often get priced on a “job shop” basis, making it singularly difficult to relate price to output. Even if a sensible pricing basis can be agreed on up front, it is not unusual to find extras on any invoice that were neither anticipated nor negotiated. A survey of service-oriented jobs at one company, for example, showed that virtually every invoice included an average of 30 percent to 40 percent in non-negotiated extras. Software development projects are notorious for running up bills far in excess of what has been negotiated and agreed on.

This opacity and laxity in pricing practices work to the buyer’s disadvantage. Without clarity about the specifications included in the price and how they contribute to cost, the buyer cannot compare alternative suppliers’ quotes before the fact and can’t challenge prices charged after the fact. In this “job shop” environment, the supplier has control over pricing, and the buyer is essentially helpless.

Establishing discipline in pricing practices is critical to any attempt to control indirect purchases. This daunting task involves creating and then enforcing a standardized pricing vocabulary across fairly large industries that have an incentive to resist standardization. The trick, once again, is to be focused and practical.

For example, a substantial portion of any company’s purchases is for temporary rental of people who are on someone else’s payroll. Secretarial temps are the prototypical example, but there are many others such as contract programmers, construction workers, lawyers, consultants, advertising agents, and so on. Most of this temporary labor is priced at the seller’s discretion: temporary agencies typically associate a price with each individual, not with each skill or position. Standardizing skill or position definitions across agencies — let alone across other labor providers — would be a difficult if not impossible task. Fortunately, most companies’ purchases of temporary labor are heavily concentrated in ten or fewer positions. Creating standard position definitions — and agreeing on the circumstances for overtime or other extra charges — is all that a company needs to capture 90 percent of the benefit.

5. Leverage the Free Market

Most of the techniques we’ve discussed — measurement metrics, quality definitions, and pricing standards — are the building blocks of a disciplined, efficient market. The question now is: What are the right techniques for approaching suppliers and markets once the building blocks are in place?

If a buyer’s objective is to minimize cost (at any chosen level of quality or value), that objective is, to some degree, at odds with the interests of suppliers. As already noted, the buyer’s cost is the supplier’s revenue. The supplier is likely to resent and resist with as much sales and marketing savvy and muscle as possible. The buyer’s challenge, therefore, is to counteract and outsmart this marketing force with reverse-marketing sophistication and power.

Knowledge of and a willingness to use free-market competition is the strongest weapon available to the buyer. Virtually every successful sourcing campaign we have observed has started when buyers explored prices with a wide variety of suppliers. The objective is not necessarily to change suppliers; it is simply to be well informed about the alternatives, conduct meaningful negotiations, and make sensible trade-offs. In well-managed situations, more than 75 percent of all competitive processes result in price reductions from existing suppliers. Buyers must be willing to take business away from those suppliers, however, if new suppliers are to take the process seriously.

Companies have to tailor the methods for accessing and leveraging the free market to their particular market. Most corporate purchasers use a “sealed bid” method; bidders submit confidential bids on the assumption that the low bid will win. In well-organized markets, with many bidders and homogeneous products, this procedure is just fine. Some economic literature argues that when these and other simplifying conditions hold, the outcome of different auction methods is likely to be identical.5

Unfortunately, the real world is seldom this simple, particularly when it comes to indirect purchases. Purchasers of indirect items are more akin to buyers in a Turkish bazaar than to clients at a Sotheby’s auction, and their tactics and behavior need to reflect this if they want to control their purchased expenses. Bidders are often unclear about the specifications on which they are bidding, and the buyer seldom has perfect information about different suppliers’ qualifications. Given these conditions, a bid is generally just the gambit in an extended dialogue. A successful negotiation has to go through multiple iterations with several competitors until level ground is achieved with respect to specifications and the floor is found in terms of price.

As the markets for indirect purchases become more organized, standard auctioning and trading techniques may become increasingly prevalent. Someday, electronic auctions may be conducted for mainframes or advertising space. Until then, however, bargaining and negotiating skills will be crucial for getting the best deal from suppliers.

Companies have to tailor the application of the five techniques to individual supplier industries and buyers. In every situation in which they have been applied, however, they have achieved significant results.

How Do Supplier Partnerships Differ?

The approaches we’ve described are aggressive, rooted in a competitive free-market worldview. That they work is hardly surprising; this is what the free-market capitalist economy is supposed to achieve.

However, the five techniques run counter to the prevailing purchasing model — the “partnership” approach to supplier management. The notion of supplier partnerships gained popularity in the early 1980s, as one ingredient in the Japanese approach to “lean production.” As Womack et al. put it, the key was to “abandon power-based bargaining and substitute an agreed-upon rational structure for jointly analyzing costs, determining prices, and sharing profits.”6 The idea gathered momentum and slowly became core to the established method of effective purchasing in the United States.

The partnership approach is popular among purchasing managers, who frequently talk about “shrinking the supplier base and establishing partnerships with a few preferred suppliers,” even when they are dealing with commodity items in extremely competitive industries. The published literature on supplier management often endorses partnerships. Some dub them the new “Golden Rule” of business.7 Others state, “In the brave new world of procurement, customers are treating their suppliers almost like their own employees.”8 There are similar statements in academic articles.9

If the free-market approach we espouse is diametrically opposed to the prevailing partnership model, which is correct? To answer this question, we first define what a partnership is and then examine the circumstances under which it would be — or might be considered — appropriate.

What Is a Supplier Partnership?

Most companies claim to have partnerships with at least some of their suppliers. Very few, however, are able to specify exactly what these partnerships amount to. One large company, for example, purchased more than $200 million of goods and services annually from one supplier for several years at a significant premium over the market. Most managers were reluctant to consider alternative suppliers because they felt they had a strategic partnership with the supplier. Yet none was able to say precisely what that partnership was. When one manager retrieved alliance documents, written more than four years earlier, he found no specific commitments by either party. The company had been overpaying for services in the name of a partnership, the terms and commitments of which were entirely unclear and the benefits of which could not be identified, let alone quantified.

This situation is fairly common. Many partnership arrangements are simply loose agreements between companies indicating that they intend to cooperate in some undefined way. As such, they have no real teeth, and their primary function is to act as broad statements of corporate goodwill. We certainly do not object to these arrangements and agree that they are desirable because they promote good feelings and encourage corporate commerce.

Our concern, rather, is with supplier partnership arrangements that do have teeth. While the specifics of such partnerships vary widely from one situation to another, from a buyer’s perspective, they always involve a significant concession, namely, forgoing the right to pursue alternatives for the duration of the arrangement. In this respect, a supplier partnership is no different from a partnership in a social or personal setting — each involves a degree of exclusivity, a commitment to work with a partner through good and bad, rather than investigate alternatives when things turn bad or better alternatives become available.

How a company gives up its right to investigate alternatives varies. Most often, the company simply commits a substantial proportion of its purchases for a significant period of time to its supplier partner.Alternatively, the company and supplier might share confidential information about each other’s product plans and costs and agree that this shared cost information, rather than free competitive evaluation, will be the basis on which to revise or renew terms.

Partnership advocates might argue that companies never really surrender the right to seek alternatives. At one level, they are correct; the right is seldom, if ever, explicitly given up, and companies are always free to investigate alternatives and benchmark against competitors. However, this concession is implicit in most partnership arrangements. Frequent investigation of alternatives would not be in the spirit of most partnerships; alternative suppliers would be reluctant to bid for business they knew they could not get, so reliable information about alternatives would be hard to obtain even if a company wanted it. Benchmarking and other circuitous methods may occasionally provide information, but meaningful market bids become largely unavailable to clients locked into partnerships.

When Are Supplier Partnerships Appropriate?

We have argued that the right to investigate and pursue alternative sources is the most powerful weapon that any buyer has. If this right is generally conceded in partnership arrangements, the question of when partnerships are appropriate is largely a question of when it is sensible to surrender this weapon.

The answer depends on two factors:

  • Are alternative suppliers abundantly available? With few viable alternatives, the right to pursue them becomes less powerful and valuable.
  • Is it easy to change suppliers? If change requires extensive disruption or cost, the threat of switching obviously loses credibility and the right to pursue alternatives becomes less potent.

Since these two questions can be answered independently, and each could have an affirmative or negative answer, from a buyer’s viewpoint, there are four supplier situations (see Figure 3). For a Type 1 situation in which there are many alternatives and change is relatively cost-free, the appropriate strategy is quite clear. Open pursuit of alternatives — by frequent competitive bidding, if possible — will almost certainly yield the best results. Since frequent change is feasible, it may even make sense to churn the supplier base if market prices warrant it.

Type 2 and 3 situations are slightly more complicated, but the right strategy is likely to be a modified version of the competitive approach in Type 1. If there are many alternatives but change is difficult or costly (Type 2) — as for providers of health care benefits to employees — it is important to continuously test the market and “back leverage” the results to secure concessions from existing suppliers. The existence of alternatives provides a credible threat to suppliers, even if the ability to switch is constrained.

In Type 3 situations, there are few alternatives, but the ability to switch without difficulty creates a constant threat that companies can use to negotiate targeted concessions from existing suppliers. In both Type 2 and Type 3 situations, having an ability to pursue alternatives creates negotiating leverage, and the sensible purchasing approach is to use this leverage to maximum advantage.

What is the appropriate approach for Type 4 situations, in which there are few alternatives and change is difficult or costly? These are possible partnership approaches, not so much because partnerships are so successful in these circumstances, but, rather, because a company has no alternative but to work closely with an existing supplier and hope that costs will be reduced and other goals met.

How frequent are Type 4 situations? In indirect purchasing, they seldom occur. Mainframe software, specialized information services, and a few others consistently fall into this category. As we discussed earlier, suppliers with a vested interest will always argue that the number of truly viable alternatives is low and the cost of change is prohibitive. If business requirements are systematically demystified, however, the facts generally indicate otherwise.

Are Partnerships Misunderstood?

One reason that partnership arrangements may have become popular in industrial environments is that Type 4 situations tend to occur more frequently when companies deal with certain direct purchases. For many subcomponents, the amount of customized effort required is large, the range of qualified suppliers is small, and development or manufacturing of supplied parts often requires considerable joint investment in engineering time and capital outlay.

Japanese lean producers seldom enter partnership arrangements by conceding the right to pursue alternatives. Since they multisource most parts, they are always benchmarking suppliers against their competitors on cost and quality. Toyota, for example, uses competitive bidding so infrequently that people often think the Japanese approach to supplier management does not embrace free-market competition. This is not necessarily correct. The approach is, in many ways, intensely competitive, but the techniques for stimulating competition and sustaining competitive pressure are often informal and culture-specific.

The U.S. fascination with Japanese partnership-style supplier management may, then, have been based on misunderstanding Japanese practice. And what made the misunderstanding particularly insidious is that, as Womack et al. point out, many U.S. companies gradually started to “single source,” thereby removing any competitive leverage they might have had.10

What we suggest — certainly for indirect purchases, but perhaps for direct purchases as well — is to reverse the logic of the prevailing model. Rather than considering partnerships the norm, and competitive arrangements applicable only in special situations, companies should establish free-market competition as standard operating procedure in the management of supplier relations, with partnerships justified only on an exception basis. It is only by relegating partnerships to their appropriately narrow confines that companies can begin reestablishing the competitive tension that is so essential to client-supplier relationships.

Conclusion

As companies begin to reduce the cost of indirect purchases, we hope that they will rethink how they manage supplier relationships. In the 1980s, companies celebrated the many virtues of Japanese-style management. This celebration achieved much but led to many mistakes. The partnership approach to supplier management may have been a misunderstood and somewhat misguided import from this period. As the star of Japanese production fades and the U.S. flirtation with Japanese techniques ends, it is time to discard relics such as the partnership approach. The capitalist free-market approach to supplier management deserves to regain its proper place in U.S. companies.

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References

1. We estimated all figures in the first section using a combination of Department of Commerce and Internal Revenue Service data, figures from a variety of industry associations, and proprietary Mitchell Madison Group databases.

2. This is based on Mitchell Madison Group’s experience in sourcing indirect purchases for many large companies.

3. For example, many purchasing systems use the Dun & Bradstreet industry coding scheme for classifying purchases. This scheme is singularly unsuited to indirect purchases; it has one code for mainframe equipment and fifty for different kinds of furniture, even though purchases of the former are an order of magnitude larger for most companies. Even if a sensible classification scheme can be established and all the relevant users and payables clerks are trained how to use it, this would solve only the problem of classifying the dollar amount of purchases into meaningful categories. This leaves the problem of locating and integrating information on volumes, so that unit costs can be computed, and the company can know that $x million was spent on printing and also that this represented a unit cost of y cents per page. Since existing sources (typically purchase orders and invoices) frequently lack this information, solving this problem itself requires significant additional effort.

4. Based on Mitchell Madison Group databases.

5. P. Milgrom, “Auctions and Bidding: A Primer,” Journal of Economic Perspectives, volume 3, Summer 1989, pp. 3–22.

6. J.P. Womack, D.T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990), pp. 167–168.

7. M. Magnet, “The Golden Rule of Business,” Fortune, 21 February 1994, pp. 60–65.

8. F. Bleakley, “Strange Bedfellows: Some Companies Let Suppliers Work on Site and Even Place Orders,” Wall Street Journal, 13 January 1995, p. A1.

9. See, for example, D.N. Burt and M.F. Doyle, The American Keiretsu (Homewood, Illinois: Business One Irwin, 1993);

D.N. Burt and R.L. Pinkerton, A Purchasing Manager’s Guide to Strategic Proactive Procurement (New York, AMACOM, 1996); and

D.W. Dobler and D.N. Burt, Purchasing and Supply Management (New York, McGraw-Hill, 1996).

10. Womack et al. (1990), pp. 158–161.

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